Taxation in Matching Markets

Abstract

We analyze the effects of taxation in two-sided matching markets, i.e. markets in which all agents have heterogeneous preferences over potential partners. In matching markets, taxes can generate inefficiency on the allocative margin by changing who is matched to whom, even if the number of workers at each firm is unaffected. While the allocative inefficiency of taxation need not be monotonic in the level of the tax when transfers flow in both directions, we show that it is weakly increasing in the tax rate for markets in which workers refuse to match without a positive wage.

We introduce a renormalization that allows for an equivalence between markets with taxation and markets without taxation but with adjusted match values. We use our equivalence to show additional properties of matching markets with taxation and to adapt existing econometric methods to such markets. We then estimate the preferences in the college-coach US football matching market and show through simulations of tax reforms that the true deadweight loss can differ dramatically from that measured without accounting for the preference heterogeneity of the matching market.

In addition to highlighting the potential for allocative distortions from taxation, our model provides a continuous link between canonical models of matching with and without transfers.

Keywords: matching markets, taxation, labor markets

JEL Classification: C78, D3, H2, J3